Economy Heats Up

Stocks, bonds, and most commodities sank today in reaction to a slew of economic reports (see below). The bottom line is that good news is bad news where it concerns the Federal Reserve. However, I wouldn’t be surprised if markets rebound by session’s end, as happened yesterday.

Recent data suggest the economy heated up last month; I’ll briefly summarize. Bureau of Economic Analysis (BEA) reports show consumer incomes grew .6% during the first month of the year, which is considered strong. Spending surged 1.8% and took everyone by surprise. In addition, inflation seems to have picked up a bit last month. The Personal Consumption Expenditures (PCE) index accelerated to an annual rate of 5.4% and December’s reading was revised up to 5.3%. Core inflation—excluding food & energy—accelerated to 4.7% in January. Next, new home sales jumped 7.2% last month to an annualized rate of 670,000 transactions. Economists were anticipating a much smaller gain. And finally, the University of Michigan’s survey of consumer sentiment showed unexpected improvement this month. Americans are apparently feeling a little bit better about the near future.

Where is all this strength coming from? Bloomberg News blames it on an “exuberant labor market” featuring an unemployment rate at a 53-year low. Of course, this is making the Fed’s inflation control job harder, which then creates uncertainty for investors. According to the U-Mich survey, inflation is expected to hover around 4% for the next year, then average down to 3% over the long run. Note that this is higher than the Fed’s long-term target of 2%. Trading in the TIPS bond market suggests inflation will average 2.4% over the next 10 years, and that figure is rising. Something has to give, and our view is that eventually the Fed will raise its target toward 3%. But in the meantime, we can expect them to hold interest rates at a higher—or “restrictive”—level for at least the balance of 2023. Of course, we’d all like to put a number to that higher, or terminal, Fed-funds rate. Current bond market trading suggest it will be about 5.4%, at which point the Fed will pause and take time to assess the trajectory of the economy and inflation.